Original Author: Musol
"Interest rates, interest rates, still interest rates!"
Readers who have been involved with the cryptocurrency market for a considerable time may understand that the cryptocurrency market is highly sensitive to U.S. interest rate decisions. Bitcoin often serves as a signal reflecting the volatility driven by the Federal Reserve. With rate cuts frequently mentioned this year, this phenomenon has intensified. Looking back at the previous market, it seems that since the Federal Reserve began actively raising rates in 2022 to combat runaway inflation, digital assets have already begun to reflect the volatility of traditional financial markets, and the Federal Reserve's interest rate decisions have indeed become pivotal moments for the cryptocurrency market.
"This correlation will not disappear quickly; if anything, it is becoming the new normal."
In fact, there is a saying in the market: "We have all become U.S. stock traders," because the cryptocurrency market not only closely follows the movements of the U.S. stock market but traders must also closely monitor U.S. economic data.
Among them, the Federal Reserve's interest rate is one of the most important data points. So, why should we pay attention to these data? What do these data mean?
What are the Federal Reserve & interest rates?
The Federal Reserve is the central bank of the United States, equivalent to the People's Bank of China, determining banking interest rate policy. However, the Federal Reserve enjoys a high degree of independence; in principle, it does not submit to the U.S. government or even the President in making independent interest rate policies. In simple terms, the U.S. President has no authority to intervene in the Federal Reserve's decisions.
The Federal Reserve independently makes interest rate decisions based on its own judgment of the macroeconomic situation, that is, raising or lowering the bank's benchmark interest rate, commonly referred to as rate hikes or cuts.
In general, the Federal Reserve will have the following three types of interest rate adjustment behaviors:
Maintain interest rates: Market expectations stabilize, and there will be no significant impact on economic signals.
Rate hikes: Suppress inflation and adopt a contractionary monetary policy.
Rate cuts: Stimulate the economy and adopt an expansionary monetary policy.
Typically, when we refer to the Federal Reserve raising or lowering rates, we are actually adjusting the U.S. federal funds rate, which is the interest generated from borrowing between banks.
Taking rate hikes as an example: When the Federal Reserve raises interest rates, that is, increases the U.S. federal funds rate, the interest/cost of borrowing between banks increases, so each bank will control costs by increasing reserves. The main means of increasing reserves is by raising deposit rates to attract people to deposit money in banks. The end result is that dollars flow into banks, and the currency circulating in the market decreases, aiming to suppress inflation.
When the Federal Reserve raises interest rates, it leads to dollar appreciation (under-supply), which means more dollars flow into banks, thereby reducing the money flowing into the stock market and other investment markets, which is unfavorable.
Similarly, rate cuts by the Federal Reserve (commonly known as "flooding the market") increase the circulating dollars, weaken the dollar, and lead more funds to flow into the stock market and other investment markets, which is beneficial.
This discussion about the Federal Reserve's interest rates will end here for now. To help readers better understand its relationship with the cryptocurrency market, this article will gradually analyze its decisions and their relationship with U.S. Treasury yields, the dollar index, the dollar index's relationship with gold and oil prices, the dollar index's relationship with the RMB exchange rate, and the relationship between Federal Reserve or central bank interest rate decisions and economic growth.
1. The Relationship Between Federal Reserve Interest Rate Decisions and U.S. Treasury Yields
U.S. Treasuries, or government bonds, commonly include 10-year and 2-year U.S. Treasuries.
The yield on U.S. Treasuries refers to the yield obtained by buying U.S. Treasuries and holding them to maturity. The calculation formula is very simple, which is to divide all the interest that can be obtained by holding to maturity by the purchase price (Treasury yield = interest at maturity / purchase price).
The coupon rate of government bonds is usually fixed, that is, the interest rate on government bonds has already been set when the bonds are issued. The interest rate remains unchanged throughout the life of the bonds, and the interest payable is calculated based on this rate.
Government bonds can be traded on the capital market, just like stocks. Therefore, their prices fluctuate at any time. This price refers to the buying and selling price, not the principal of government bonds. The principal and coupon rate of government bonds are only used to calculate the repayment amount, and the market buying and selling price of government bonds is independent.
Since the prices of government bonds fluctuate, the denominator used to calculate U.S. Treasury yields will also fluctuate, determining that U.S. Treasury yields will vary.
When U.S. Treasury prices rise, Treasury yields fall; conversely, when Treasury prices fall, Treasury yields rise.
Thus, those who are not well-informed may mistakenly believe that the rise in Treasury yields is due to a booming Treasury market, where everyone is buying Treasuries. In reality, it is because people are selling off Treasuries, leading to a drop in Treasury prices and an increase in yields. A decrease in Treasury yields indicates that people are buying Treasuries, boosting their prices, leading to a drop in yields.
Replacing U.S. Treasuries with government bonds works the same way. Whether it's U.S. government bonds or Chinese government bonds, an increase in government bond yields indicates that people are selling off government bonds, while a decrease in yields indicates that people are buying government bonds.
The yield on government bonds is inversely related to the prosperity of the government bond market.
Chart 1: U.S. 10-Year Treasury Yield Trends from December 1 to December 6, 2024
What is the relationship between the Federal Reserve's interest rate decisions and fluctuations in US Treasury yields?
The Federal Reserve's interest rate policy determines the levels of bank deposit and loan rates. When the Federal Reserve raises interest rates, bank deposit rates will increase, and depositing money in banks can yield higher interest returns. Meanwhile, the interest rates on U.S. Treasuries are fixed until maturity. When bank deposit rates rise, it attracts more people to deposit money in banks or purchase financial products calculated at the new interest rates, reducing the demand for Treasuries and leading to a decrease in Treasury prices and an increase in Treasury yields. Conversely, when the Federal Reserve cuts interest rates, it encourages people to reduce deposits and increase Treasury purchases, pushing Treasury prices up and yields down.
Typically, the most sensitive to Federal Reserve interest rates are 2-year government bonds because their shorter duration means fluctuations in bank rates will more clearly prompt people to compare the interest rates of deposits and government bonds over the next two years. In contrast, the longer tenured government bonds have less immediate impact from short-term bank rate fluctuations on the interest rates of deposits over the next ten years, where many rate hikes and cuts may occur.
Therefore, the Federal Reserve's rate hikes will lead to an increase in U.S. Treasury yields, while the Federal Reserve's rate cuts will lead to a decrease in U.S. Treasury yields.
The Federal Reserve has continuously raised interest rates from 2022 until the second half of 2024, with rates climbing from 0 to 5.5% (Chart 2). Accompanying this round of rate hikes, the 10-year U.S. Treasury yield rose from below 2% to as high as 5% (Chart 3).
Chart 2: U.S. Bank Benchmark Interest Rate Trends from January 2022 to December 2024
Chart 3: U.S. 10-Year Treasury Yield Trends from January 2020 to December 2024
1. The Relationship Between Federal Reserve Interest Rate Decisions and the Dollar Index
The dollar index refers to the exchange rate index of the dollar against other national currencies in the international market. A higher dollar index indicates dollar appreciation, while a lower index indicates dollar depreciation.
Rate hikes by the Federal Reserve mean both bank deposit and loan rates will rise. The increase in deposit rates will attract more people to deposit money in banks, reducing the currency circulating in the market. The increase in deposit rates represents the cost of banks obtaining funds, and rising rates mean higher costs, prompting banks to increase loan rates. Higher loan rates mean that enterprises, individuals, and governments will face increased borrowing costs, thus reducing borrowing and similarly decreasing the currency circulating in the market.
This means that the Federal Reserve's rate hikes lead to more dollars being deposited in banks, thus reducing the dollars circulating in the market.
In the foreign exchange market, the appreciation or depreciation of a currency is directly determined by the supply and demand relationship for that currency. A decrease in the supply of dollars ultimately leads to a strengthening of the dollar index.
A decrease in the Federal Reserve's interest rates means that both bank deposit and loan rates will fall. The decrease in deposit rates leads to more people unwilling to deposit their money in banks, increasing the currency circulating in the market; the decrease in loan rates will encourage people to borrow more, which similarly increases the currency circulating in the market.
This means that rate cuts by the Federal Reserve lead to more dollars flowing into the market, thus reducing the dollars saved in banks.
In the foreign exchange market, an increase in the supply of dollars ultimately leads to a weakening of the dollar index.
Thus, the levels of the Federal Reserve's interest rates are positively correlated with the dollar index. The levels of bank interest rates in each country are similarly related to the exchange rates of their currencies in the foreign exchange market.
Chart 4: Dollar Index Trends from July 2021 to December 2024
3. The Relationship Between Federal Reserve Interest Rate Decisions, the Dollar Index, and Gold and Oil Prices
In the international market, gold and oil are priced in dollars, meaning that when the dollar appreciates, its purchasing power increases, allowing the same amount of dollars to buy more gold and oil, leading to a decrease in gold and oil prices; conversely, when the dollar depreciates, gold and oil prices will rise.
Chart 5: Gold Price Trends from January 2021 to December 2024
Chart 6: Oil Price Trends from January 2021 to December 2024
Understanding this logical relationship, we can see the close connection between Federal Reserve interest rate decisions, the dollar index, and gold and oil prices.
When the Federal Reserve raises interest rates, the dollar index strengthens, and the prices of gold and oil fall; when the Federal Reserve cuts interest rates, the dollar index weakens, and the prices of gold and oil rise.
This is the theoretical logical relationship between them and the direct impact of Federal Reserve interest rate decisions and the dollar index on gold and oil prices, but it does not imply that the actual trends in gold and oil prices must conform to this relationship. The prices of gold and oil depend on a multitude of factors.
4. The Relationship Between Federal Reserve Interest Rate Decisions, the Dollar Index, and the RMB Exchange Rate
In fact, with the previous knowledge foundation, this is quite simple. In the foreign exchange market, a stronger dollar means that other currencies exchanged for it will depreciate; conversely, a weaker dollar means that other currencies exchanged for it will appreciate.
Therefore, when the dollar appreciates, the RMB depreciates relative to it, and vice versa.
When the Federal Reserve raises interest rates, the dollar index strengthens and the RMB exchange rate weakens; conversely, when the Federal Reserve cuts interest rates, the dollar index weakens and the RMB exchange rate strengthens.
Chart 7: RMB Exchange Rate Trends from January 2021 to December 2024
It should be noted that in the foreign exchange market, the RMB is commonly quoted against the offshore RMB exchange rate. Its quote is not based on how many dollars 1 RMB can exchange for, but rather how many RMB 1 dollar can be exchanged for, as the international common currency is the dollar. Therefore, when this index rises, it means the RMB is depreciating, meaning that 1 dollar can exchange for more RMB; conversely, when this index falls, it means the RMB is appreciating. Don't confuse this relationship.
In a floating exchange rate market with free capital movement, when the Federal Reserve raises interest rates, the currencies of other countries are passively devalued against the US dollar. To avoid allowing their own currency to depreciate relative to the dollar, other countries' central banks need to follow the Fed's rate hikes to hedge against the impact of the Fed's rate hikes on exchange rates. Conversely, when the Fed lowers interest rates, other countries' currencies are passively appreciated against the dollar. To hedge against the impact of the Fed's rate cuts on exchange rates, other countries' central banks need to follow the Fed's rate cuts.
This leads to a loss of independence in national monetary policy, such as in Canada, South Korea, Brazil, Argentina, and Hong Kong. If they do not want to lose the independence of their monetary policy, they must passively accept the impact of the Federal Reserve's interest rate decisions on exchange rate fluctuations, which also reflects the hegemony of the dollar.
This is why we often hear many countries expressing dissatisfaction with the Federal Reserve's interest rate policy in the news, as the Fed's interest rate decisions directly impact the exchange rates of many countries' currencies and the interest rate decisions of their central banks.
As for whether these criticisms have merit, those who understand will know. The monetary policy of any country should and can only start from its own national interests, and it cannot simultaneously consider the interests of other countries. Even if one tries to consider the interests of other countries while formulating monetary policy based on its own interests, one still lacks the ability to achieve this.
Therefore, criticisms from other countries regarding the Federal Reserve's monetary policy are meaningless and ineffective. Only by being strong enough can one avoid being constrained by others.
5. The Relationship Between Federal Reserve or Central Bank Interest Rate Decisions and Economic Growth
The market is an invisible hand that directs economic trends, but this invisible hand has its inherent flaws, that is, it lacks a braking function. Just like a car without brakes, it cannot predict that a traffic accident will occur and brake in advance. The market lacking a braking function means it cannot predict and avoid impending economic recessions and crises. Completely allowing this invisible hand of the market to freely direct economic development will inevitably lead to a cycle of boom and bust.
Chart 8: Economic Cycle Diagram (Please excuse the old chart)
Chart 9: The U.S. Economy Entering the Great Depression After Prosperity in 1929
Chart 10: The Dow Jones Industrial Average Before and After 1929
The reason behind this is that the blood of the market is capital, and capital seeks profit. Wherever there is money to be made, capital will flow there; where profits are high, capital will flock there. This is the rule by which this invisible hand directs the economy.
For example, when an industry emerges with high demand, prices soar, and profits are high, it attracts capital to flood into that industry, increasing supply until it shifts from under-supply to balance and ultimately to oversupply, leading to price declines or crashes, profit declines, and ultimately losses, causing the industry to collapse. After a crisis, the market self-corrects, capital exits, and supply decreases until it returns to undersupply. This cycle repeats itself, representing the economic law of the market—from under-supply to balance to oversupply, from growth to saturation to recession to crisis.
The entire economic development follows this pattern.
It is precisely because we have recognized this pattern and the inherent flaws of the market as an invisible hand that we need to install a "brake" on the market economy, rather than allowing it to run freely; this "brake" is "government macro-control."
Before a crisis occurs, we should predict and take measures in advance to prevent the crisis, like applying the brakes appropriately.
Interest rate policy is an important tool in macroeconomic regulation.
When the economy continues to grow strongly, to avoid overcapacity leading to recession or even crisis, the Federal Reserve will raise interest rates to contract the money supply in the market, attracting people to deposit money into banks and reduce consumption, thereby reducing demand for goods. Rising interest rates compel enterprises, individuals, and governments to reduce borrowing and investment, leading to a decrease in the supply of goods.
Conversely, when economic growth is weak or in recession, to promote economic prosperity, the Federal Reserve will expand the money supply in the market by lowering interest rates. People are less willing to deposit money in banks and more inclined to consume, increasing demand for goods. The decrease in interest rates encourages enterprises, individuals, and governments to borrow and invest more, leading to an increase in the supply of goods.
Therefore, the Federal Reserve adjusts the balance of market supply and demand through interest rate decisions, striving to ensure that the economy can spiral upwards positively and avoiding issues like overcapacity, vicious inflation, deflation, recession, depression, and crisis.
The ideal situation we hope for is economic growth alongside stable prices, or price growth far below our income growth. This is the optimal economic growth scenario.
Our income growth allows us to purchase more and better goods, and enterprises can earn more profits. Under this premise, the faster the economic growth, the better, indicating that our social wealth is continuously increasing, and the happiness index is continuously rising, leading to sustained prosperity. This is the virtuous spiral of economic growth.
For instance, China's nearly 40 years of rapid economic growth since reform and opening up represents a virtuous spiral, with GDP growing rapidly, people's income levels continuously rising, price increases far below our income growth rates, and people's purchasing power continuously enhancing.
Readers might also consider the current situation.
From 1978 to 2017, China's economy (GDP) grew at an average annual rate of about 9.5%, while the average annual growth rate of per capita disposable income was about 8.5%, and the average annual increase in price levels was about 4.86%.
Chart 11: China's GDP Growth After Reform and Opening Up
It should be noted that GDP essentially refers to total social output, which can be simply understood as the total amount of goods (services) produced by society. The more produced, the wealthier the society. This output is measured in monetary terms, meaning that total social output must be converted into money, which is often heard as trillions. However, this value is just a number. The number itself has no actual meaning; we need to look at the actual goods (services) represented by this number to measure the true wealth of society. Hence, the distinction between nominal GDP growth rate and real GDP growth rate exists.
Nominal GDP refers to the GDP growth rate calculated at current prices without considering price changes. This does not mean it is the actual GDP growth rate. For example, if the current price level has risen compared to before, then if the total social output has not changed, the calculated GDP will be higher than the previous GDP, indicating GDP growth due to the difference in price calculations. In reality, total social output has not increased, and social wealth has not changed. The actual GDP growth rate excludes the impact of price changes and calculates the current GDP against the previous GDP at the same prices. Only under this premise does a change in current GDP compared to previous GDP indicate a true change in social total output and social wealth.
Let's return to the relationship between interest rate decisions and economic growth.
The Federal Reserve's interest rate decisions depend on judgments of the current economic situation, with key indicators being GDP growth rate, CPI, and new employment numbers. Among these, the core indicator is CPI, or the inflation index, which is also the target of regulation.
CPI is regarded as the most reflective indicator of economic conditions. When the economy grows, people's incomes increase, purchasing demand rises, and prices go up. When the economy is in recession, people's incomes decrease, purchasing demand falls, leading to price declines.
Therefore, the Federal Reserve hopes to maintain CPI within a reasonable range (around 2%-2.5%).
When above this range, it indicates that economic growth is too fast and overheating. To avoid supply and demand imbalances leading to economic recession and crises, the Federal Reserve will raise interest rates.
When below this range, it indicates weak economic growth, recession, or depression. To stimulate economic growth, the Federal Reserve will lower interest rates.
If within this range, it indicates that economic growth is in a virtuous spiral phase, and the Federal Reserve will remain inactive.
Therefore, the Federal Reserve's interest rates are not in absolute direct or inverse proportion to economic growth rates or CPI.
When the economy grows reasonably and sustainably, interest rates may remain unchanged or continue to decrease, and there may also be appropriate rate hikes to control prices. Generally, maintaining low-interest rates over the long term is conducive to stimulating economic growth.
The first chart here has appeared before, so I won't elaborate much. From the first quarter of 2021 to the second quarter of 2022, the year-on-year growth rate of CPI in the United States rose continuously, even reaching 9%. Inflation levels kept rising, and during the same period, GDP grew rapidly, indicating strong economic growth.
Chart 12: Year-on-Year Trends of U.S. CPI from January 2021 to October 2024
However, to avoid falling into a vicious inflation cycle, the Federal Reserve began raising interest rates in 2022 and continued until the first half of 2024. With the continued rate hikes, the year-on-year growth rate of CPI fell continuously to 3%, and the GDP growth rate also fell from a high point of 6%-7% to 2%-3%. Therefore, starting in the second half of 2024, the Federal Reserve will begin a rate-cutting cycle.
Chart 13: U.S. GDP Growth Rate from Q1 2021 to Q3 2024
The relationship between interest rate decisions by central banks in various countries and economic growth in those countries follows the same pattern.
First, I would like to sincerely thank all readers for getting this far. If you have reached this point, it indicates that you already have a clearer understanding of interest rates. Now, let's discuss some of the impacts of the Federal Reserve's interest rate cuts.
The multidimensional impact of the Federal Reserve's rate cuts.
In today's increasingly globalized context, as a significant barometer of the global economy, we all know that the Federal Reserve's rate cut policies undoubtedly have far-reaching international influence.
Rate cuts directly lead to a decrease in dollar deposit rates, causing capital to overflow from the banking system in search of higher returns. This not only promotes cross-border investment activities but also accelerates signs of global economic recovery.
However, for the cryptocurrency market, the impact of this capital flow is not straightforward; we need to understand that its influence is not immediate but multidimensional.
The Double Mirror of the Market
On one hand, the increase in market liquidity brought by rate cuts indeed enhances investors' risk appetite, making them more willing to pour funds into high-risk, high-return areas. Mainstream cryptocurrencies like Bitcoin, due to their unique decentralized attributes and potential for high returns, have become favorites among many investors.
Furthermore, rate cuts are often accompanied by the depreciation of the dollar, further enhancing the appeal of cryptocurrencies as safe-haven assets (which is also what has been subtly happening in the market this year), attracting a large influx of funds seeking to preserve their assets.
On the other hand, historical data shows us another perspective. Although rate cuts theoretically should benefit cryptocurrency prices, in practice, this influence is often constrained by multiple factors—economic uncertainty, market sentiment fluctuations, changes in policy expectations, and the complexity of investor behavior can lead to contrary outcomes in the cryptocurrency market after rate cuts. For example, during economic recessions or periods of heightened market panic, more people might prefer to withdraw funds from high-risk markets, including cryptocurrencies, to avoid potential losses.
Looking back on the past 35 years of U.S. interest rate cycles, we can see that the impact of rate cuts on the cryptocurrency market is not constant. In the 1980s to 1990s, although the Federal Reserve's rate cuts aimed to stimulate economic growth and combat inflation, the rebound in asset prices often lagged behind policy implementation and was strongly interfered with by economic uncertainties.
Since the 21st century, with the rise of the cryptocurrency market, the impact of rate cuts on it has become more complex and variable. During the 2008 financial crisis, the Federal Reserve's rate cuts and quantitative easing policies indeed provided strong support for risk asset markets, including cryptocurrencies. However, this support is not unconditional and enduring. The wave of rate cuts following the outbreak of COVID-19 in 2020 pushed the cryptocurrency market to unprecedented heights, but this rise was more a result of market sentiment and risk-averse demand rather than solely the effect of rate cut policies.
The Federal Reserve's rate cut policy has a multifaceted, complex, and uncertain impact on the cryptocurrency market. Capital is not charitable. Although rate cuts can increase market liquidity, enhance investors' risk preferences, and possibly support rising cryptocurrency prices, this influence is neither unidirectional nor absolute. In today's complex and ever-changing environment, we should remain calm and cautious when facing monetary policy adjustments, such as rate cuts, and consider the multidimensional factors such as the economic environment, market sentiment, and policy expectations. Only by doing so can we gradually remain unbeatable in the ever-changing market.
As the tides of life ebb and flow, few return from the rivers and lakes.
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